Municipal bonds are actually one of the most valuable investments in your portfolio because they, more than any other asset class, allow the small investor to outperform the market assuming you are willing to take on a liquidity premium.
I am fairly heavily invested in municipal bonds, and they take up somewhat more than 15% of my asset allocation (I am 72/28 right now). Since I hold some bonds in my kids' 529, I would say it is the largest fixed income invesmtent I currently own.
I favor individual municipal bonds because you don't pay the expense ratio fee, you can control the maturity, and more importantly you can control the credit quality. Even Vanguard's fund is about 30% in single A or lower (including more than a few BBB bonds) whose performance you can't really trust because investing this low opens you up to risks, and just because something is unlikely doesn't mean it's impossible.
The best part about individual municipals is that the yields are actually higher due to the volume premium. While smaller lots, lots of face value of 5 or 10 have a higher markup, the demand for them is generally so low that if you find a discount broker that presents lowball bids, more often than not you get a very nice boost to your returns.
Understandably, if you find a municipal bond that has a higher yield than other bonds of its credit quality and maturity, more often than not it is a sign that there is trouble brewing and the market is spelling problems. On the other hand, yields of 50-100 basis points higher, particularly at the shorter end of the curve, are not unheard of.
Example: I recently bought a bond due in Jan 2013 for a 1.35% tax free yield; it was pre-refunded in US treasuries. The only difference is that it was a lot of 5 bonds, far less liquid that US treasuries. In this market, 1.35% after tax return for under 2 years is pretty good. A week or two before, I purchased another pre-refunded, again escrowed in US Treasuries, that was due in 1-2021 with a 4.05% yield, tax free when US treasuries due in 2011 were paying merely 3.4% or so.
In this case, as long as you keep to maturity, you basically pocket the yield difference as a risk premium that is never realized.
So to me, municipals actually outperform and are more attractive than any other fixed income due to the bump in yield.
Again, warning to the higher yielding bonds that seem to be well rated! If it's too good to be true it is.
I suggest before you start this way, read Larry Swedroe's bond book, Annette Thau's bond book, maybe 1 or 2 other books on municipals, as well as Larry Swedroe's alternative investment book which covers fixed income pretty well.
I use Stoever Glass www.stoeverglass.com
I am very happy with them. Ask for Russell Stoever and say you are a new client. Tell him the doctor who posts online recommended you, and you are looking for bonds of similar quality and lot size as he (stable AA/AAA). Favor pre-refundeds as well.
Lastly, I also recommend paying to join the website www.municipalbonds.com
and look up bonds here before buying by the CUSIP number.
It will tell you what the moody's rating is, when it was most recently given, what the most recent credit report was, and any negative credit watch or downgrade expectations are.
Watch for bonds that are at least AA-/AA3 and also not
on a negative watchlist. Sometimes a bond will be insured. There are one or two monoline insurers still investment grade. One is even rated AA1, but on negative watch list. Always
buy bonds based on their underlying credit rating, but sometimes if the rating holds for the insurer, it will say AA1/negative because that one insurer is the higher of the two. However, ask Russell Stoever or dig deeper yourself what the underlying credit rating is. It may still be worth buying because even if it's AA2 or AA3 and stable, that one more highly rated (but on a negative watchlist) insurer will show up.
So welcome to the world of municipals. You will find it one of the most gratifying investments you ever made as long as you're careful to stay at the creme de la creme, so much so that you will delay funding your 401k so you can buy munis. Of note, that's exactly what I did in Jan/Feb and stopped my contributions so I could buy more municipals into that falling market.
Hope that helps.
1. Do not confuse strategy with outcome
2. Those who fail to plan plan to fail
3. Do not assume the unlikely is impossible, and
4. Be ready to deal with the consequences if you do.